Chapter Eleven

A Boom in Busts

A History of Recession

The Great International Reply Coupon Scam

Our financial system is built on trust. People looking to earn a nice return on some savings seek out sound investments, and those investments are critical to our economic growth. By directing our savings towards lucrative investment, the financial system makes everyone richer. However, from time to time someone comes along with a story that is too good to be true and shatters that trust.

Open Video Transcript

This is the story of a man named Charles, an Italian immigrant who came to the United States in 1903 with $2.50 in his pocket and $1 million in hopes, who devised a clever plan to make money by exploiting a little loophole in an international treaty signed just three years after he stepped onto American soil. --Charles first found work in a coal mine near Boston where he met Rose Maria Gnecco, a stenographer, and they got married. He went to work for her family’s small fruit stand, but when it failed, he decided it was time to go into business for himself. He had this idea to sell advertisements in a catalog that would be sent to businesses, and in the summer of 1919, he reached out to his contacts in Europe to see if there was interest. A few weeks later, he received a letter from a company in Spain asking for more information. Inside the envelope was an International Reply Coupon, something which he had never seen before. Charles wrote back and asked about the coupon his contact had used to mail the letter. He learned that these coupons could be purchased in the U.S. and many European countries and allowed someone to mail something internationally from any of those countries. International reply coupons were established by an international postage treaty in 1906. They were vouchers that could be traded for stamps in any country that signed the treaty, which included the U.S., Spain, and Italy among others. The purpose of the coupons was to make it convenient for people to prepay international return postage without having to exchange currencies in small amounts – which was completely impractical. Remember, this is a time where mail was your only way of sending messages back home. So many people travelling to Europe would pick up these coupons before they left America, allowing them to send letters back home without worrying about foreign postage. And, of course, people in Europe travelling to America would do the same. While most people thought this was just a nice convenience that made a minor expense simple, Charles saw an opportunity to make many millions of dollars. --Arbitrage is the simultaneous buying and selling of securities, currency, or commodities in different markets in order to take advantage of differing prices for the same asset. The scheme Charles had in mind was to try to buy International Reply Coupons cheaply in one country, but then sell them for more money in another country. For example, suppose that the reply coupons were half the price in Italy as they were in the U.S. I could take 100 American dollars and convert them into Italian Lira, then use the Lira to buy the reply coupons and ship them back to America. Since the treaty requires America to accept the Italian coupons, Charles could sell them at the American price and double his initial investment. The money-making potential was limited only by the amount of money he had to send to Italy to buy these coupons. There was one hang-up though, which was the reason no one had tried this before Charles recognized the opportunity himself. --In 1906, when the postage treaty was signed, all the countries involved had adopted a monetary system known as the Gold Standard. The U.S. had adopted the gold standard in 1833 by fixing the price of gold at $20.67 per ounce. That meant that if you had $20 bill, you were able to go to a kiosk set up by the treasury department and exchange it for nearly one ounce of physical gold. This system prevented the creation of too much paper money, since the government didn’t want to risk running out of gold reserves to pay those requests.More importantly for our story here is that when multiple countries adopt the Gold Standard, the exchange rate between their currencies becomes fixed. If I can convert my American money into a set amount of gold, and then I can turn that gold into a set amount of a foreign currency, then the exchange rate is set to the ratio of each country’s fixed price for gold. That meant that the postage treaty could set the prices of the coupons in each country so that they were the same price everywhere. You wouldn’t be able to buy reply coupons in Italy, and then take them to America and sell them for more because the prices were set in accordance with the exchange rates to make this impossible. But this turned out to be a double-edged sword. The prices of the coupons could not change, and that made arbitrage impossible unless the exchange rates changed. The writers of the treaty just never considered that could happen. --Then came World War I. Many countries abandoned the gold standard because they needed to print more money in order to pay for the war and they didn’t have the gold reserves to back it up. This meant exchange rates could float with the market, and the fixed prices of the international reply coupons suddenly presented a huge opportunity. By 1919, it was possible to spend only a few cents on reply coupons in Spain and Italy that could then be brought to the U.S. and sold for a full dollar’s worth of postage stamps. The only problem was that you had to transport the physical coupons from Spain and Italy to the U.S., which was costly, and then you needed to have a buyer who would pay the full U.S. price. But Charles was convinced that the prices of the coupons had fallen so low in war-torn Europe that he would still have a healthy profit margin. --Charles didn’t have a lot of money, so he sought investors to put money into his plan. He established a new company in January of 1920 and reached out to friends and acquaintances explaining his plan to them. In the first month of operations, 18 people invested a total of $1,800 in Charles’ system. Just one month later, he wowed them all by paying them back a total of $2,400, which was a 50% return. Mind you, if the stock market grows by 50% in a whole year it is considered one of the best years ever. Charles had stumbled upon a rate of return higher than just about any other investment out there, and word spread quickly. After the initial success, investors poured in! People were mortgaging their homes and investing their life savings in the Securities Exchange Company. Most didn’t even take their profits, opting to reinvest them to earn another 50% every 45 days! By June of 1920, six short months after starting the business, people had put $2.5 million in Charles’s company (the equivalent of about $32 million today), and Charles was suddenly a millionaire, taking a cut of all the gains. He bought a beautiful mansion in Lexington, Massachusetts and settled into the good life. But there was a problem. And there is a clue to it on the screen right now. --Charles’ success attracted a lot of attention, and some skeptics started to wonder how he was getting the coupons back to the U.S. and converting them to cash? Even just the initial investment of $1800 was enough to buy 53,000 postal coupons. How did he ship them so cheaply, and turn them around so fast? By June, Charles had 15,000 investors, and he would have needed ships the size of the Titanic to actually transport all the coupons needed to be turning the profits he was claiming. A Boston finance writer suggested there was no way Charles could be pulling this off and claimed he was a scam artist. Charles insisted he was honest, and just didn’t want to give away his methods for fear that they would be copied. He sued the writer for libel and won! He got $500,000 in damages! Shortly after that though, one of Charles’s clients, Joseph Daniels, wanted to pull out his money to try to cash in on a Gold Rush, but Charles refused. Daniels sued him for his own money and lost, with the courts saying that the agreement he signed with Charles did not allow him to pull out his money all at once like that, but customers got worried, and many demanded their money back, storming the company’s offices. To calm their nerves, Charles walked out to the angry mob with a stack of money and paid them one at a time, moving down the line calmly, and quelling their fears. But little did they all know that Charles was giving them the last money the company had, and he breathed a sigh of relief that enough people turned away and didn’t ask for their money that he had enough to cover the withdrawals. The company was now bankrupt. It was all a lie. Because there is something I haven’t told you. And that’s Charles’s last name. --Ponzi. Charles Ponzi had started his scheme in January of 1920, but on November 1st of that same year, he pleaded guilty to fraud. His story was widely publicized, and while many had tried this scheme of lying about returns to keep new investor money pouring in before, from then on it bore his name. Nevertheless, this is a story about trust. Our economic growth is powered by investment that is financed by borrowing money and paying it back with a little interest. That system incentivizes people to save money by rewarding them with a return on those savings. But for this system to work, people must trust each other, and from time to time, that trust fails, and the consequences can be dire.

Money and Banking

Money and banking both have a bad rap, and are often the subjects of scorn and ridicule. Leave it to your economics textbook to take the contrarian opinion that money and banking are the solutions to problems, and not problems themselves. Money makes it easier to engage in trade, the lifeblood of the economy. Banks make it easier to turn savings into investment, the essential maintenance of a growing economy. But it took a long time for both to develop into the institutions we know today.

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Money, contrary to popular belief, is a wonderful thing. It solves the tremendous problems presented by the barter system, which requires people to find and negotiate mutually beneficial trades of some goods and services for other goods and services. The reason the barter system is problematic is because it suffers from the double coincidence of wants, where each party to a trade must have something the other party wants. A farmer who grows carrots but wants some cows needs to find some other farmer who raises cows but wants a bunch of carrots. Sacrifices have to be made, and value gets lost as the carrot farmer trades for some onions and then trades those for some clothes and bread and uses that to get just one cow instead of two. It’s just no good. --Money solves this problem by acting as a medium of exchange. You can sell what you produce - whether that be carrots, cows, or video lesson on economics – in exchange for money, and then use that money to buy whatever it is you need or want. Money fulfills one of three important functions when it is accepted as payment for goods and services in this way. But there are two other functions that money serves in our society which help solve more than just the problems of the barter system. Money is a unit of account. It is how we measure and compare the value of goods and services. I can compare the height of two people by measuring them. The unit of height is feet and inches. If I say one person is 6 feet tall and another is 5 feet tall, you can understand their relative heights. I can also compare the value of two things, and the unit of value, or unit of account, is money. If I say one car costs $20,000 and another costs $25,000, you can understand their relative values. Money lets us compare the value of everything in the same way a ruler lets us compare the height of everything. This allows us to measure and compare the trade-offs we face and make prudent decisions. The third function of money is that it is a store of value. It is how we hold value over time. It is odd to think of it this way, but things would be a lot harder if we had to choose what we wanted to consume immediately after producing something. Money lets us produce something of value, sell it, and then hang on to the value until we decide what to spend it on. It’s really this last function that this whole chapter is about. --Before we get to that though, we should mention two different monetary systems. One is called Fiat money, and I have an example of fiat money right below it. The other is called commodity money and I have an example of that one too. Can you spot the difference? It’s not just that one has green on it and the other has blue. It’s that one says “One Dollar” at the bottom and the other says “One Silver Dollar” at the bottom. Fiat money is currency backed by law. This is what the U.S. has had since 1971 and certainly what you are most familiar with. The money that we use has no intrinsic value. It’s just worthless pieces of paper that we have decided to imbue with value. The confidence we have in it is founded on its legal status. If you pull out a dollar, you will see printed on it: “This note is legal tender for all debts, private and public.” In other words, the money has the backing of the government. Commodity money is currency backed by stuff. Throughout most of human history, that stuff has been gold or silver or some other type of precious metal. But if all the movies and television shows I’ve watched are to be believed, even things like cigarettes are used a commodity money in prisons. Anything will work so long as it has intrinsic value, meaning that it is a commodity people would want even if it wasn’t being used as money. In the case of the dollar bill pictured, it could be turned in at a bank for a set quantity of silver. Fiat money and commodity money both have their advantages and disadvantages. Commodity money causes a lot of silly behavior and wasted resources, like trying to dig up rocks in the ground that people don’t really want. It is also prone to a lot fluctuation in value, as the value of the underlying commodity can change rapidly based on supply and demand. Fiat money doesn’t have these problems, but it does have the problem of putting the government in charge of the amount of money in circulation, which can lead to significantly higher inflation. In some ways, understanding why almost every economy in the world has switched from some form of commodity money to fiat money over the last century is the big story of these next few chapters. --Our modern monetary system finds its roots in the practices of medieval goldsmiths. These goldsmiths would take in gold ore and purify it, separating it from rock, and forming it into transportable bars and coins as well as making jewelry out of it. But gold is very heavy, incredibly heavy really, and people didn’t really want to carry it around. So, goldsmiths started to offer storage services. They built vaults that would be guarded, keeping people’s gold safe for a small fee. Thus, banking was born. In return, the depositor would get a certificate for their deposit which they could bring back to withdraw their gold at any time. It wasn’t long before people started trading these certificates, signing them over to someone else as a form of payment. Eventually, the banks just started printing their own paper money which could be brought back and exchanged for a fixed amount of gold. --Just a few hundred years ago, most loans were privately arranged between the borrowers and the lender. People lent out their savings directly, seeking out profitable investment opportunities. But the goldsmiths-turned-bankers realized they could do this themselves. People would deposit their gold into the bank and would be given paper money in return which they could use as a medium of exchange. But the banks then offered them the opportunity to save the cash they weren’t using which the bank would then turn around and lend out at interest. The bank would take a cut of that interest and pass some of it on to the depositor. Many people had no expertise at all in judging whether an investment was promising or not, and banks could specialize in that judgement. This opened the opportunity to grow your money with interest to many people who would never consider it otherwise. If you remember your Solow model, investment is critical for an economy, and by increasing the savings which could then be used to finance investment, banks are helping the entire economy grow. Modern banks continue to serve this function, and they use the money you deposit with them to make loans. But modern banks have evolved quite a bit from the olden days. --For most of U.S. history, and especially from 1837 to 1864, the U.S. did not have a federalized banking system. Each individual state had their own rules about banks, and each bank was printing their own money. You can see here just a small sample of all the different types of currency issued by banks. Shopkeepers in these times got a giant catalog each year like a phone book or a directory which pictured all the different legal notes in circulation so they wouldn’t get swindled by forgeries. During the Civil War, a national banking act created rules for chartering a national bank, each one of which was required to issue the same uniform currency. But all the state-chartered banks still operated as they did before, printing their own currency. Eventually this would change with the creation of the Federal Reserve system.

The Market for Loanable Funds

Credit markets, called here the market for loanable funds, bring together borrowers and lenders. Borrowers take out a loan, which they have promised to repay in full with interest. The terms of any specific loan are up to whatever the borrower and lender agree to, but the options on offer to any borrower will be determined by the forces of supply and demand in the market for loanable funds.

Open Video Transcript

People borrow money for all kinds of reasons. For most of us, the only times we think about borrowing money is to buy a house or a car, go to school, or make some other kind of big purchase. But a more common reason people borrow money is to finance investment in a business. There are lots of examples for why people need to do this. Michaela might have the experience and know-how to run her own urgent care facility, but she doesn’t have the money it would take to buy all the equipment she would need, so she might turn to a bank to borrow $250,000 to get started. Tony might already have a successful HVAC repair business with several employees. But it’s a competitive industry and Tony’s company operates with small profit margins. If one of his trucks breaks down, he might need a loan to finance the purchase of a new van. Or even if he just wants to hire another technician and have another van in his fleet, he might need a loan to finance that expansion. Meanwhile, Christian might have a successful business which designs robotic equipment, but he identifies 3D printers as a potentially lucrative new product line for his company. He might need a loan to buy the equipment needed just to tinker and toy with potential ideas and develop the product he thinks will be a big seller. Starting a business, upkeep, expansion, and research & development are all common reasons that businesses or business owners will borrow money. But they won’t just do so without thinking about it first. Whether or not that borrowing is a good idea depends on how successful they expect that idea to be. For example, Michaela might project revenues for her first years in her business plan, and those projections will mean she is only profitable if she gets an interest rate on her loan under 5% per year. Any higher, and there would be a risk that even if her business is getting lots of customers, she won’t make enough money to pay back the loan. Tony might have a better projection, and the new van is sure to be worth it even if the interest rate on the loan is as high as 7%, but no higher. While Christian might see this potential market as worth pursuing only if he can get the loan under 3% interest. Notice that if the interest rate was 3%, then these three people would borrow a total of $380,000, because all three would find the terms agreeable. But if the interest rate rose to 5%, Christian would drop out and decide not to borrow the money, so now the total amount borrowed would be $290,000. And if the interest rate was 7%, Michaela would say that was too high, but Tony would still feel comfortable, so only $40,000 would be borrowed. As the interest rate rises, fewer people borrow money, and vice versa. --With millions of people and businesses and even governments like cities and towns looking to borrow money, we can form the demand for loanable funds. Loanable funds are just the total amount of money that will be borrowed. As the interest rate charged on money borrowed goes down, more and more business opportunities become feasible, as does more and more borrowing for buying a home or a car or going to school. So, the demand for loanable funds is downward sloping. As the price of borrowing (the interest rate) goes down, the quantity of money borrowed (the loanable funds) goes up. What this graph does is just describe how borrowers will react to changes in the interest rate. But where does this money they are borrowing come from? --People and corporations save money for the future. To entice them to deposit those savings in a bank, those banks will offer accounts which accrue interest. Most savings accounts banks advertise these days offer pretty miniscule interest rates that are hardly worth it. Part of this is just the modern environment with low interest rates all around, but other financial institutions like Goldman Sachs, Robinhood, and Synchrony offer better interest rates on money put into savings accounts with them. But low interest rates mean there is little to gain by holding off on consumption. If the interest rate you can earn on your savings is very high, you might forgo a new car or a home renovation, or even just cut back a little here and there to put more into the savings account. Higher interest rates mean you will be earning a lot more each year, and it might be worthwhile to postpone consumption now so you can buy even more stuff later. For this reason, we expect the amount of money people save in financial institutions, or lend directly themselves by buying corporate or government bonds, will increase as interest rates rise. --All this saving is what forms the supply of loanable funds. As the interest rate rises, more and more people will be willing to park some of their money in an interest-bearing account from a financial institution which is pooling all those savings together and making loans with the money. So, the supply of loanable funds is upward sloping like this. Ok, now let’s put the two together. --The market for loanable funds consists of both the demand for loanable funds and the supply of loanable funds. Notice that this market is just like any other we can represent with supply and demand. There is a supply and a demand for bread, and the forces of competition push the price to the point where the quantity supplied is equal to the quantity demanded. You may think that bread is different from money, that you can actually go to a store and buy bread by paying some money for it, but you can’t go to the store and buy money by paying some money for it. But actually, you can! It’s just that the store is called a bank, and the money you pay to buy some money is called the interest rate. Competition between banks and other lenders will push the interest rate to the equilibrium where the amount people save and supply for loans is equal to the amount people want to borrow at that interest rate. One thing that is really tricky about the market for loanable funds is that someone can be both on the supply side and the demand side. Take a big company like Apple, for example. They do a lot of research and development, and so they would typically need to borrow a lot to finance it. But they are so profitable, that they have plenty of cash just sitting around to spend. You might have thought about an example like this yourself, where a person has enough money themselves that they could start their business without borrowing. But as any economist would point out, they are indeed borrowing from themselves. They could take that extra money and stick in an interest-bearing account, earning the market interest rate on their savings. By using their money to finance a business investment, they are forgoing that interest, and so in that way they are still paying the interest rate on the money they use for the investment. Remember, economics is all about opportunity costs, and the interest rate is the opportunity cost of using your money now instead of later. --But here are the key takeaways from the market for loanable funds:- Interest rates are set by the market for loanable funds. Some large banks might have enough market power to influence interest rates, but for the most part the interest rate you have to pay on any loan is set by the forces of supply and demand. - The amount of investment is determined by this market. Remember your Solow model, where we assumed that the population would save a fraction of their income, and that savings would be used to pay for the investment needed to maintain the capital stock after depreciation? Well, now we have this model for loanable funds that explains how that savings rate and investment will be determined. Slowly but surely, we are building an even better model for the economy at large. - Credit markets will segregate by risk level. By that I mean that while we look at this as one big market, in reality there are a lot of different markets for loanable funds. There is a market for mortgages, a market for student loans, a market for business loans, a market for corporate bonds and so on. Each market has different fundamentals, such as a different amount of risk that the loan won’t be repaid. Nevertheless, we can aggregate all those markets into this one big one for analysis but remember that this is basically representing the average of all of those markets, setting the level of the interest rate from which all the other interest rates will be derived. - And lastly, the supply of loanable funds is sensitive to sentiments. The money used to make loans comes from people who are saving their money for the future. If they are worried about the investments being made, they might decide to pull their money out. Think back to Charles Ponzi and the mob of people he tried to calm down once they heard he was refusing to pay back one of his investors. People can get spooked en masse, and if they all pull out their money at the same time, the supply of loanable funds will collapse, and this market could freeze up. Gee, I wonder if that’s ever happened before…

Practice Questions

1. In an economy which adheres to a Gold Standard, what would you expect to happen to interest rates when new gold deposits are discovered and mined?

Reveal the Answer

Interest rates are determined by the market for loanable funds. So, the question we need to ask ourselves is whether the discovery of gold would impact the supply or demand for loanable funds.

The demand for loanable funds is determined by the desire to borrow money for personal consumption or business investment. The discovery of gold doesn't impact either one in a direct way.

The supply of loanable funds is determined by the amount of money that is saved. In an economy that adheres to a Gold Standard, money is gold. With an increase in the amount of gold in circulation, the amount put into savings is bound to increase.

An increase in the amount of currency in circulation will increase the supply of loanable funds. At the new equilibrium, the interest rate will fall.

2. Amber works as an accountant making $120,000 per year, but has been thinking about opening her own accounting firm. In order to get started, she would need a loan of about $300,000 for initial expenses, which she could take out at an interest rate of 5%. Amber thinks through her business plan carefully and projects that her firm would earn $600,000 in annual revenues, but face annuals costs of about $470,000. Considering only economic motivations, should Amber open her own firm?

Reveal the Answer

If we are only considering economic motivations, Amber's new firm would need to provide her with a higher income than her current job, which pays $120,000 per year. According to her business plan, she expects to make $130,000 per year with her own firm. However, we need to consider the loan she has to take out to start the business.

The relevant cost to her decision is the interest payments she would have to make on the loan, which are 5% of $300,000, or:

0.05*300,000 = 15,000

So, we deduct from Amber's profits the $15,000 in annual interest payments, which leaves her with $115,000 per year, less than her salary at the firm she works for. The economics recommends Amber keep her job and not start her own firm. Of course, she may be willing to sacrifice the income to be her own boss, or perhaps she is willing to roll the dice and take the chance that her own firm will be more successful than her estimates.

Note also that if the interest rate falls to 3.33% or less, then Amber would be economically advised to try it out with her own firm.

Irrational Exuberance

A financial bubble is a cycle where the market value of an asset rises rapidly, peaks, and then suddenly falls in value. Financial bubbles are nothing new, but since the Industrial Revolution they have become more common. One key reason why is the availability of credit, where the price increases are fueled by money borrowed on the belief that the investment can't lose.

Open Video Transcript

One of the most famous examples of a financial bubble is Tulip Mania. It happened in the Netherlands almost 400 years ago. The Dutch made use of something called Futures Contracts, which was a contract to buy something in the future. In order to secure a good price for their harvest, farmers would often sell a futures contract for it. Essentially a buyer would commit to purchase the crops at an agreed upon price in the future. That buyer could also sell their rights to make that purchase. If they signed a deal to buy tulips, for example, at 100 florins, but the going price of tulips rises to 200 florins, they could sell their contract to someone else for something in between, letting them cash in now while the new buyer is now able to buy the tulips at a nice low price. Well, in November of 1636, the futures price of a somewhat rare and prized tulip called “The Viceroy” skyrocketed to over 2500 florins for a single flower. Comparisons between this much time and space are hard, but that translates to something like $37,000 per flower! The skyrocketing prices were seen as a great investment to many, and the rush to strike it rich on tulips overwhelmed just about everyone. The painting shown here was painted just a few years later, depicting the traders as monkeys caught in a frenzy. It is said that a sailor, in his infinite stupidity, mistook one of the flowers for an onion, picked it up, and ate it. And he was jailed! But the frantic buying up of these tulip futures kept driving the price higher. And to be clear, people weren’t buying tulips, they were buying the right to buy tulips later. Then on February 5th, 1637, the party ended, and in the blink of an eye, the bubble burst and prices fell to a couple florins. This burst ruined many, and it is said to have caused a recession for the Dutch, though these claims are disputed. Some believe there was a change to the way futures contracts worked for tulips, whereby the buyers could opt out of the contract for a small fee, meaning there wasn’t much risk is making the agreement. But those who bought high ended up losing everything they invested.Bubble like this have long captured people’s attention, and filled their dreams with ‘what ifs’, but the real thing I want you to notice is that you can probably think of a few events like this. But they are all modern. The dot-com bubble. The housing bubble. Bitcoin. These sort of things used to be rare, but now they happen all the time. --Financial bubbles like this are not entirely irrational. It may be crazy to pay $37,000 for a flower, but it might still be rational and profitable so long as there is someone else dumb enough to pay more.This is called the Greater Fool Theory. So long as there is a greater fool than me, I might make some money on this thing, even though I don’t really believe it is worth so much. --Almost a century later, another famous bubble erupted in Britain on the eve of the Industrial Revolution. The South Sea Company was founded in 1711 as a private-public partnership to consolidate debt held by the British government. In return for creating a financially beneficial situation for the British government, the company was granted a monopoly on all trade with South America. It was a pretty lucrative deal and was working extremely well for the East India Company that controlled British trade with India. Except that at the time, Britain was at war with Spain, and Spain controlled South America, making trade impossible. But the South Sea Company was helmed by a guy named Robert Harley, who happened to also be essentially the minister of finance for Britain, and a powerful politician. He steered Britain to a peace agreement with Spain which opened up some avenues for profit for the company – most especially and unfortunately in the slave trade. At this point, stock in the company was offered to the general public, though you couldn’t buy it outright the way you buy stock in a company today. Essentially what you had to do was buy government bonds, and then you could exchange them for shares in the South Sea Company. Things were slow-going at first, but by 1717 things were looking up for trade in South America. --Enter John Blunt, a charming man who worked for a young company call the Sword Blade Company. The company started out making French-style swords but acting on the company's behalf Blunt persuaded Robert Harley to reintroduce lotteries to fund the government. Blunt and the Sword Blade Company ran the lotteries and earned fees for doing so. Over the years, the Sword Blade Company began operating essentially as a bank, taking in deposits and making loans. When the South Sea Company was created, Blunt was essentially on their board of directors. By 1718, Blunt was the most influential voice on the board, and he had the South Sea Company issue new shares at a higher price to the public, meaning you needed to buy more government bonds to trade for each share. He convinced the company to issue enough shares that the company would consolidate all of the debt owed by the British government, including the debt held by the Bank of England (which was then a private company). It was a transparent attempt to diminish the power and influence of the Bank of England, which would favor his own Sword Blade Company. The South Sea Company and the Bank of England got into a bidding war for that government debt, but the South Sea Company won by bribing members of parliament to allow them to sell shares of the South Sea Company for cash, not just in exchange for government debt, which had been illegal before but now made shares in the South Sea Company the hottest commodity in town. In 1720, Blunt issued tons of new shares, which sold in just hours to the general public who believed the company would hold vast influence on trade and the government. The share price, which had been £120 in January, was up to £750 in June. So, Blunt offered new shares for £1,000 and people took the bait. But at the end of the day, the South Sea Company was still making very little profit compared to other companies. And when there was no one left to buy shares, the only thing left for people to do was sell them. --Something new at the time which is extremely common today was buying on margin. Buying on margin means the investor borrowed money in order buy some asset which they hoped to sell later for more than the repayment on the loan. These days, usually a person will open a margin account which allows them to borrow money from their broker or the company which gave them the account. That person is then able to buy stocks and other financial assets with the borrowed money. The gamble is that the price of those assets will rise, and they will be able to sell them, pay back the loan, and still have a tidy profit left over. These days, trillions of dollars are borrowed every year for that purpose, but in the 1720s, it was a new concept. A lot of people borrowed money to buy shares in the South Sea Company, certain that the share price would keep rising and they would be made rich without every putting in a dime of their own money. But when there wasn’t any more credit to fuel the buying, the price stopped rising, and it soon came time for the borrowed to pay back their lenders, meaning they had to sell what they had at a loss. When lots of people are in that situation, a small drop in the price can set off a cascade of selling as panic sets in and these investors try to jump off the sinking ship before their losses get too big. --There are five phases of a financial bubble. First comes displacement, where there is an initial increase in the value of an asset as investors become enamored with a new opportunity. Prices rises slowly at first, but as word spreads of the initial success there is a boom as people jump in with the hopes of making a quick profit. But the leap in the price is like a drug that intoxicates investors, putting them in a state of irrational exuberance where they believe the prices will just keep on rising, making them even richer. But when the price fails to rise any more, some people decide it’s time to take those short-term profits and sell what they have. Those who think “better safe than sorry” push the price down with their sales, and that sets off a chain reaction among the investors who have taken on too much risk in the hopes of continually rising prices. As they panic and sell, prices plummet and the bubble pops. Throughout most of human history this was a problem for rich people. They were the only ones with money sitting around and too much time on their hands. Bubbles like these would make some people a fortune as the expense of some other rich person, but rarely did the fallout extend to ordinary people who weren’t involved in the mess. But then the industrial revolution happened, and we all became rich people with extra money to throw at these silly whims. And our growing economies elevated the importance of banks as institutions which would facilitate investment in new capital. But those banks are run by people too, people who sometimes make judgements as bad as these.

A Boom in Busts

The business cycle is the repeated expansions and contractions of the economy over time. Before the Industrial Revolution, these cycles were generally determined by the weather's impact on that year's harvest. But after the Industrial Revolution, the swings in the economy started to become more frequent and more volatile. Over the course of the 19th century, there were many dozens of financial panics which started to spill over into industry, throwing people out of work and slowing our economic progress.

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In 1907, this man, pictured here with a knife, locked John D. Rockefeller, Treasury Secretary George B. Cortelyou, the wealthy banker Lord Rothschild, and Chairman of City Bank James Stillman in a room and demanded they give him $100 million dollars of their own money. And they did. This is the story of why. --As economies grew and finance became more important to that growth, many countries adopted a central bank. Remember, initially every bank issued their own currency on the deposits customers made with them. As certain banks grew in size, some countries simply gave one of them a monopoly over that process and some regulatory powers to help manage the financial markets. In Britain, for example, the Bank of England was given control of the pound, their currency, making them the only ones allowed to issue new money. They also tasked the Bank of England with ensuring stability in the banking system by managing the credit markets with sound rules and regulations. With a Central Bank at the helm, financial bubbles that pop and cause a panic could be managed so that they didn’t spread throughout the whole financial sector by ensuring continued access to credit. The U.S. flirted with the idea of a central bank and had very limited versions of one in our early years and after the Civil War, but not like others. But that would eventually change. --Financial panics started to become more and more common as industrialization enriched the formerly poor. In the mid-1830s, America was on the rise and expanding westward at a rapid pace. But a bad harvest in wheat in 1836 left many families without food or income. President Andrew Jackson also issued an order that all sales of federal land, which were considerable at the time, had to be made in gold or silver, not with the paper money issued by banks. Without new deposits, and seeing higher withdrawals of gold and silver, banks increased their interest rates to attract more savings, but ended up popping a price bubble for cotton that further devastated farmers. --Banks are usually able to handle the ups and downs like this, but every few years the disruptions would form a sort of perfect storm. Banks offer a valuable service in taking deposits and lending them out, then sharing in the profits of the loan with their depositors. At the time, banks took in deposits of gold, and there were a lot of lucrative opportunities for lending for land purchases and cotton projects. But unpredictable economic turbulence led a lot of these investments to fail, while at the same hard times led many to withdraw their savings. But the banks they were withdrawing from didn’t have enough gold to meet those demands, because so much of it was lent out. This creates a panic, where people hear that the bank they trusted to keep their savings was at risk of collapsing. Even if just a small fraction of their loans had defaulted, no one wants to be the person left holding the empty bag, and so they rush to the troubled banks demanding their deposits back. Banks try to call back the loans they made, but for some it just isn’t enough, and they end up closing their doors. In the aftermath of the Panic of 1837, the U.S. lost half of its banks to bankruptcy, and with them many people lost their entire life savings. --A bank run occurs when a bank experiences an extraordinarily large volume of withdrawals driven by a concern that the bank will run out of liquid assets (cash). The problem is that banks don’t have enough money in their reserves, the deposits they keep on hand to cover withdrawals, because they have used that money to make loans. Those loans are assets for a bank, money that will be paid back with interest, and so they can help a bank stay afloat. Normally, when banks get into short-term trouble and they don’t have enough money to meet withdrawals, they borrow from other banks to make up the difference based on the value of these assets. At the time they borrowed through “Clearinghouses”, which were made up of a group of banks who would lend reserves to each other when one was in need. But in major panics like 1837, no one is willing to lend to each other, and the whole system freezes up. --When bad luck would concentrate on a particular industry, it would often lead to financial panic. In fact, you could often predict them, as they would happen cyclically with the farming season. The whole financial system just wasn’t set up to deal with shortfalls fast enough. In the past, these panics would diminish the fortunes of the rich, but would rarely result in a significant or long-lasting downturn in the whole economy. But after the Great Enrichment, everyone was rich enough to be impacted. And since sustained economic growth depends on credit to finance it, financial panics threatened that prosperity. After the Panic of 1837, production fell for seven years before recovering, leading to higher unemployment. The panics weren’t just getting more frequent, they were getting worse. --Outside of a small group of historians and economic historians, the Long Depression has mostly been forgotten. But the nation went through over 20 years of economic turmoil, experiencing a sequence of recessions that kept unemployment high, left multiple generations of people to scorn banks, and weakened economic growth. Disasters like the Great Chicago Fire in 1871 and the Great Boston Fire in 1872 were a negative shock to the economy which compounded with the burst of a speculative bubble in railroad companies. In 1873, the U.S. also abandoned silver as a form of money, moving to a strict gold standard. The downturn was severe, and the recovery very slow, as many labor unions turned to fruitless strikes. Central to the persistent problems were monetary disturbances. The complete dependence on gold left the U.S. vulnerable to international pressures which attracted gold from the U.S. to other countries. Prices in the economy remained depressed, which also kept wages down and discontent high. --The hot-button political issue of those decades of economic recession was bimetallism, which was pushed by a political movement called “Free Silver”. They wanted to monetize silver again, helping people in debt, especially farmers, by allowing them to repay their loans with either gold or silver. The debtor would be able to repay with whichever currency was more inflationary, reducing the burden of their loan at the expense of the lender. And while the heated political disagreements that I’m sure ruined many a Thanksgiving dinner has been forgotten, the cultural impact is still here. The leader of the Free Silver movement was a politician named William Jennings Bryan. He was the Democratic nominee for president three times, losing each time, which frustrated the movements supporters. One of them was L. Frank Baum, who wrote the political polemic into a children’s story called The Wizard of Oz. In the original story, Dorothy had to travel the yellow brick road – representing the gold standard – wearing silver slippers. They changed them to ruby slippers for the movie because silver was too overtly political. Dorothy was the innocent Americans. Scarecrow represented the brainless farmers. Tinman represented a frozen industry. And the Cowardly Lion represented William Jennings Bryan, who lacked the courage to do what was needed to be done to win. --The Industrial Revolution, brought on by a new culture of growth, made us rich. But with those riches came the problems of rich people. The web of credit meant that instability in the financial sector would spill over into every other sector of the economy. And with more borrowing and lending needed for the economy to grow, the crises became more frequent and more devastating. --By 1907, people had had enough. So, when Otto Heinze attempted a shady maneuver to manipulate the stock price of United Copper and failed so spectacularly that he took down the Knickerbocker Trust Company – one of the biggest and most respected financial houses on Wall Street – the rich and powerful were spurred to action. John Pierpont Morgan, known around town as J.P., was the most powerful and respected banker perhaps in the world. He dispatched his man, Benjamin Strong, to Knickerbocker to assess the damage. After concluding it was hopeless for them, Strong was sent to the other big financial firms to determine what the fallout would be. When one big bank went down like this, people would panic and a run on banks would start, spreading the financial contagion to otherwise healthy banks. Morgan identified the critical stopping points, where an influx of cash would be able to prevent the dominos from falling by satisfying depositors. Morgan assembled the top bankers along with the U.S. Treasury Secretary and got them all to throw into a fund they would use to save the financial industry from another collapse. They used the money to infuse everyone else with cash, and the panic stopped. People were not as worried that they would lose their money after seeing someone like J.P. Morgan so willing to risk so much of his own. The U.S. still endured a deep recession, though without the high level of bank failures and credit crises, and everyone had finally agreed on one thing…--It was time to solve this problem for good. As the political cartoons at the time show, people were worried about leaving the saving of our entire economy up to the whims and wills of the super-rich. Senator Nelson Aldrich got the Congress to pass a minor reform bill which did almost nothing, but it did establish a commission to study the monetary system and banking reform. And Aldrich himself chaired a sub-committee which was to study the possibility of establishing a central bank. And that’s exactly what they would do.

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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Dr. Goegan Explains...

Example Question
Kim has taken out a $9,657 loan which she must pay back in one year with 3% interest. At the same time, Kim has gotten a cost-of-living raise at work, and her salary has increased from $54,046 per year to $58,757 per year.

How much has the share of Kim's income going to the loan changed as a result of this increase to her salary?

Example: If I owe someone $100 and I make $1000, then that debt is 10% of my income. If my income increases to $2000, then the debt is now only 5% of my income. So, the share of my income going to the debt changed by -5%.

Your answer should be a negative number, in percentage form, rounded to two decimal places.

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Dr. Goegan Explains...

Example Question
Richard is a landscaper who is planning to break away from his employer and start his own landscaping company. In his first year, Richard expects to make $24,000 in profit from his business after he pays all expenses (including for his own labor). To get started, he needs a $18,917 loan to purchase needed equipment. The bank has offered him a one-year loan. What is the maximum interest rate Richard is able to accept for this loan?

Put your answer in percentage form (e.g. 30.57 not 0.3057) and then round to two decimal places.

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